REUTERS - Israel's short-term interest rates could be cut below zero and other monetary policy tools considered should the shekel strengthen further and threaten the economy's export-led recovery, a senior Bank of Israel official said.

The central bank unexpectedly lowered its benchmark interest rate ILINR=ECI to a new all-time low of 0.10 percent from 0.25 percent on Monday, citing the shekel's appreciation.

The currency, long overvalued against the dollar and euro, had weakened in recent months on the back of slower growth, lower interest rates and a very low inflation outlook. But some of that depreciation had reversed ahead of Monday's rate cut.

Bank of Israel Deputy Governor Nadine Baudot-Trajtenberg said while the central bank was "relatively comfortable" with its 2015 growth forecast of 3.2 percent "we needed to ensure that no further (dollar-shekel) depreciation takes place."

"We had concern that looking forward, without the extra push, we would not necessarily maintain our growth estimate," Baudot-Trajtenberg said in an interview with Reuters.

Against the dollar, the shekel ILS= weakened by 15 percent between July and late January but reversed course and gained 2.6 percent in the month since the prior rates decision. More important to the central bank, the shekel's effective exchange rate had depreciated 10.4 percent between August and December but appreciated 7.6 percent since then.

Along with a strong bounce-back from last year's Gaza war, which hit third-quarter growth, the shekel's depreciation had helped to fuel higher exports. That in turn contributed to annualised growth of 7.2 percent in the fourth quarter of 2014. Early indications are that growth has continued so far in 2015.

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Baudot-Trajtenberg said exports -- some 40 percent of Israel's economic activity -- were crucial to growth this year. "Domestic demand is decent but not vigorous and investment is not growing at all," she said, noting the forecast for global trade was still subdued.

"Clearly, part of this recovery we saw in the fourth quarter was through the export sector and part of the export growth was attributable to (the fact) that the exchange rate was in a much more comfortable situation than we had seen previously."

Interest rate?

The shekel was trading at 3.925 per dollar on Wednesday. It had weakened to as much as 3.96 on Tuesday in the wake of the surprise rate cut, from 3.86 prior.

The 15-basis-point cut was the first time in a decade that the central bank had moved by less than a quarter-point.

"We did what we thought was needed," said Baudot-Trajtenberg, who became deputy to Governor Karnit Flug last March.

She said rates could still go down if needed.

"If you look at central banks in many countries, you see them experimenting with negative interest rates, which we had thought was never possible," she said.

"I don't think we have completely exhausted the interest rate tool. And we are also considering other tools."

Further reductions, as well as the use of quantitative easing, depends on how the economy responds, she said. One positive is solid U.S. growth, although Europe, Israel's largest overall trading partner, is still struggling.

"We are sensitive to both economies and at least one is going in the right direction," Baudot-Trajtenberg said. "When we need to move will depend on what is happening in these economies."

One other factor in cutting rates has been persistent negative inflation. The annual inflation rate was -0.5 percent in January versus -0.2 percent in December. Part of the drop was due to a big decline in energy costs as well as a one-time decrease in electricity prices.

"The interpretation of the low inflation environment is partly due to these supply shocks," Baudot-Trajtenberg said.

The inflation rate is expected to 0.7 percent in one year -- below the government's annual target of 1 to 3 percent - and 0.8 percent in two years. But she noted that longer term inflation expectations were within the target.

Baudot-Trajtenberg downplayed the impact of the latest rate cut on already sizzling housing prices, saying long-term rates mattered more and that "clearly, the solution is an increase in (housing) supply."

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